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On its face, you would think that “Retirement Accounts” such as IRAs, 401(k)s, pensions, and profit sharing plans would be the easiest part of a loved one’s estate to administer. The beneficiary should just make a claim, a withdrawal, or roll over the account, right?

Actually, a lot of thought should go into the choices that are made prior to actually acting.

“Retirement Accounts” pose definite challenges to an estate and trust administration, due to the income tax consequences, the interaction of the estate tax if that is an issue, as well as the beneficiary and Required Minimum Distribution (RMD) rules. It’s easy to slip up, resulting in additional tax burden or financial difficulties that otherwise wouldn’t be a problem if you let your professionals guide you through the process.

Like annuities, these assets are IRD and therefore do not receive a step-up in tax cost basis. Withdrawals from Retirement Accounts generally create taxable income. And just like a tube of toothpaste—once you squeeze out the toothpaste, it is impossible to get it back in the tube—the same holds true for Retirement Accounts. Once you make a taxable distribution, even if by mistake, it is impossible to reverse the mistake.

For these and related reasons, there’s a lot of confusion regarding Retirement Accounts. This confusion is justified, because Retirement Accounts are subject to a plethora of complicated rules. When and how a Plan Participant must take distributions from Retirement Accounts differs from the rules governing spouses who inherit Retirement Accounts.

And those rules differ for non-spouse beneficiaries who inherit Retirement Accounts.

When a Plan Participant owns various 401(k) accounts, pensions, and profit sharing plans, he or she can usually roll those over into a single IRA without incurring income taxes or penalties. As an example, Father (the “Plan Participant”) has several different IRA and 401(k) accounts scattered about from several employers during his working career. Rather than maintaining all of these accounts with their separate investment decisions and distribution rules, Father decides to perform a tax-free rollover of all of these accounts into one IRA account.

When Father dies, if his spouse (Mother) survives him, then she may roll over his IRA into her own IRA, tax-free.

Before Mother rolls over Father’s IRA, she should make certain that rolling over the account immediately after Father’s death is a good decision. If, for example, at the time of death, Father was over 59½ years of age, but Mother was not, there could be a problem with an immediate rollover if Mother will require distributions to support herself.

If Mother rolled over Father’s IRA before Mother attained age 59½, she could not take distributions without first paying a 10% excise tax on top of whatever income taxes she would otherwise owe on the transfer.

Assume, for example, that Father dies this year with a $500,000 IRA. Father was 65 at the time of his death and Mother was 57. Mother will require $15,000 annual distributions from the IRA in order to meet living expenses. If Mother first rolls over the IRA into her own and is in the 25% marginal income tax bracket, then Mother pays an excise tax of $1,500 plus income tax of $3,750 for total taxes of $5,250. The excise tax effectively boosts Mother’s taxes on the IRA withdrawal by 40%!

Under this scenario, rather than rolling over Father’s IRA, the better alternative until she attains 59½ is to keep Father’s IRA as an “Inherited IRA.”  This way, Mother can take distributions from Father’s IRA to support herself under the “Single Life Table” under the appropriate Treasury Regulations without the excise tax penalty.

If instead Mother left the IRA as an Inherited IRA until she was 59½, she would still be able to take out the $15,000 and would still owe the $3,750 of income tax, but would not be subject to the $1,500 of excise tax.

If, on the other hand, Mother is over age 59½ and she does not require distributions from the IRA to support herself, then she would likely benefit the most by rolling over Father’s IRA into her own. Under this scenario, she won’t be required to take any Required Minimum Distributions (RMD) until she attains age 70½.

Contrast this result with Inherited IRAs.  Non-spouse beneficiaries have no choice between rolling over and taking their inheritance as an “Inherited IRA.” With Inherited IRAs, the beneficiary will always have a RMD every year, regardless of their age. In other words, RMDs are required for all beneficiaries of Inherited IRAs (even Roth IRAs), even if they are under 70½ when they inherit them.

If, for example, Son (age 40) inherits an IRA from Father, Son will have RMDs for the rest of his life. I’ve seen many beneficiaries make the mistake of withdrawing their entire Inherited IRA balance, believing that a rollover is possible, when in fact it is not. Just like the tube of toothpaste, once the “withdrawal” is out of the tube, it is nearly impossible to put it back in, resulting in significant income tax bills, as well as the loss of tax-deferred growth for the rest of the beneficiary’s life.

In order to both thwart that outcome and to better protect IRA inheritance from a beneficiary’s divorcing spouse, creditors, or predators, IRA trusts are sometimes used. When a trust is named as the beneficiary of an IRA, the trustee must be careful to ensure that the “identifiable beneficiary” IRS rules are satisfied to ensure that the primary beneficiary’s lifetime is used to compute the RMDs. Those rules require:

  1. That the trust is valid under state law;
  2. The trust is irrevocable or by its terms will become irrevocable upon the death of the IRA owner;
  3. The beneficiaries of the trust are identifiable; and
  4. A copy of the trust instrument is provided to the IRA custodian by October 31 of the year following the IRA owner’s death.

 

If one of these terms are not met, then depending upon the age of the Plan Participant when he or she died, the untaxed income inside of the IRA could all be taxed within five years of the Plan Participant’s death.

IRA trusts may also be used in situations where the deceased hoped to split the IRA interest between a current income beneficiary and remaindermen who would inherit after the income beneficiary’s death—in other words, to provide both for the decedent’s spouse and the decedent’s children in second marriage situations.

When this happens, there could be a struggle between distributing all of the RMDs every year for the spouse or accumulating the income inside of the trust to preserve it for the next generation. Since accumulating income inside of a trust creates very high income tax liability, these issues should be discussed during the loved one’s estate administration to ensure that everyone is on the same page.

When there are multiple beneficiaries named in an Inherited IRA, one danger is that the withdrawal schedule that is mandated under what is known as the “Single Life Table” under Treasury Regulation §1.401(a)(9)-9 will be under the oldest beneficiary’s life.  When you have a significant spread of years between the oldest potential beneficiary and the youngest, this could mean an acceleration of income withdrawals, resulting in higher annual income taxes and the potential loss of years of tax-deferred growth.

The rules are so vast and complicated that there are entire books written on this subject. I can’t possibly cover all of the tax rules and options available to the family in one chapter of a book intended to provide a broad overview of the estate and trust administration process when a loved one dies. I do plan to write a future book detailing more of the rules and options, but for purposes of understanding the administration of a loved one’s estate, I hope to have driven home the point that there’s more to Retirement Accounts than simply making a claim for the IRA balance.

Suffice it to say, therefore, that before taking any action with regard to any Retirement Account that will be inherited either by a spouse or any other family member, consultation with knowledgeable tax professionals is important.

While I don’t wish to knock professionals in the financial field, I am going to offer a word of warning. While many financial professionals are excellent at managing investments, many don’t know or understand the complicated tax and trust rules that apply to Retirement Accounts when a loved one dies, such as with the very few examples I offer in this blog. Please make sure that you have assembled a good team that includes a knowledgeable attorney and CPA.

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